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6-merchandise inventory


CHAPTER 6 Accounting for Merchandise Inventory
Charles T. Horngren

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Learning Objectives
1. Account for inventory by FIFO, LIFO, and average cost methods 2. Compare the effects of FIFO, LIFO, & average cost 3. Apply the lower-of-cost-or-market rule to inventory 4. Measure the effects of inventory errors 5. Estimate ending inventory by the gross profit method
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Determining Number of Units Sold
? Companies determine the number of units sold and the units in inventory from perpetual inventory records. Exhibit 6-1(p.312) shows how inventory appears on the balance sheet and cost of goods sold appears on the income statement. ? Ending inventory = no. of units on hand x unit cost Cost of goods sold = no. of units sold x unit cost Unit cost = purchase price – purchase discount
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Inventory Costing Methods
? Costing methods GAAP allows:
1. 2. 3. 4. Specific Unit Cost FIFO (first-in, first-out) LIFO (last-in, first-out) Average Cost

?

Exhibit 6-3(p.314) compares the cost flows of the three most popular methods.
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Specific Unit Cost
? When units are sold, the specific cost of the unit sold is added to cost of goods sold ? Used for items that differ from unit to unit, such as real estate and automobiles ? Seldom used in practice.

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First-In, First-Out (FIFO)
Oldest Costs Cost of Goods Sold

Recent Costs

Ending Inventory

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First-In, First-Out (FIFO)
Beginning Inventory
Then we sell 4 shirts for $20 each. What costs should be assigned to Cost of Goods Sold?

First-In, First-Out

Purchase 5 shirts Inventory = $48
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Cost of good sold = $42
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FIFO :Journal Entries
GENERAL JOURNAL
DATE DESCRIPTION
REF

DEBIT

CREDIT

Accounts Receivable ($20 x 4) Sales Revenue To record sales on account Cost of Goods Sold Inventory To record cost of sales
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80 80

42 42
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First-In, First-Out (FIFO)
? Sales Cost of Goods Sold Gross Profit $80 42 $38

? consistent with the physical flow of goods. ? Exhibit 6-4, p.316. ? Practice:S6-1, 4, p.334.
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S6-1
Perpetual Inventory Record

FIFO
ITEM: Bicycles DATE 1-Jun 16 30 30
QTY. Purchases UNIT COST TOTAL COST Cost of Goods Sold UNIT QTY. COST TOTAL COST Inventory on Hand UNIT TOTAL QTY. COST COST

20

80 $1,600 10 15 $70 80 $700 1200

10 $70 10 $70 20 5

$700 $700

80 $1,600 80 400

Cost of ending inventory for June = $400
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S6-4
June16 Inventory (20×$80) Accounts Payable 30 Accounts Receivable Sales Revenue Cost of Goods Sold Inventory
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1600 1600 3,500

3,500
1,900* 1,900
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Last-In, First-Out (LIFO)
Recent Costs Cost of Goods Sold

Oldest Costs
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Ending Inventory
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Last-In, First-Out (LIFO)
Beginning Inventory
Then we sell 4 shirts for $20 each. What costs should be assigned to Cost of Goods Sold?

Last-In, First-Out

Purchase 5 shirts
Inventory = $42
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Cost of good sold = $48
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LIFO: Journal Entries
GENERAL JOURNAL
DATE DESCRIPTION
REF

DEBIT

CREDIT

Accounts Receivable ($20 x 4) Sales Revenue To record sales on account Cost of Goods Sold

80 80

48

Inventory To record cost of sales
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48
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Last-In, First-Out (LIFO)
? Sales $80 Cost of Goods Sold 48 Gross Profit $32 ? favored by many companies because it often results in the highest cost of goods sold and the lowest income tax. ? Exhibit 6-5, p.317. ? Practice: S6-2, p334.
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S6-2
Perpetual Inventory Record LIFO ITEM:Bicycles RECEIVED SOLD BALANCE UNI UNIT T UNIT TOTAL COS TOTAL COS TOTAL DATE QTY. COST COST QTY. T COST QTY. T COST 1-Jun Balance 10 $70 $700 16 20 80 $1,600 10 $70 $700 20 80 $1,600 30 20 80 $1,600 30 5 70 350 5 70 350

Cost of ending inventory for June = $350
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Average Cost
? The average cost of each unit in inventory is assigned to cost of goods sold
Cost of Inventory on Hand

Number of ÷ Units on Hand = Average Cost

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Average Cost
Beginning Inventory
Then we sell 4 shirts for $20 each. What costs should be assigned to Cost of Goods Sold? Compute the Average Cost Units Cost Beginning inventory 3 $30 Purchases 5 60 Total 8 $90 Average = $90/8 = $11.25

Purchase 5 shirts
Inventory = $11.25 x 4 = $45
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Cost of good sold = $11.25 x 4 = $45 chapter6-merchandise inventory18
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Average Cost: Journal Entries
GENERAL JOURNAL
DATE DESCRIPTION
REF

DEBIT

CREDIT

Accounts Receivable ($20 x 4) Sales Revenue To record sales on account
Cost of Goods Sold

80
80

45

Inventory To record cost of sales
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45
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Average Cost
? Sales Cost of Goods Sold Gross Profit ? Exhibit 6-6, p.318. ? Practice: S6-3, p.334. $80 45 $35

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S6-3
Perpetual Inventory Record Average ITEM:
RECEIVED UNI T QTY CO TOTAL QTY . ST COST . SOLD BALANCE

DATE 1-Jun Balance 16 20 80 $1,600 30

UNIT COST

TOTAL QTY COST .

UNIT COST

TOTAL COST

10 30 25 $76.67 $1,917

$70 76.67

$700 2,300 383

5 $76.67

Cost of ending inventory for June = $383
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Comparing Effects of Different Methods
? FIFO: most popular, followed by LIFO, then average cost. (Exhibit 6-7, p.320)

LIFO 31%

FIFO 46%

Avg 20%

Other 3%
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Comparing Effects of Different Methods
Ending Inventory Gross Profit
FIFO $48 $38 LIFO $42 $32 Average $45 $35

During a period of rising prices, (Exhibit 6-8, p.320) ? FIFO: lowest COGS, highest gross profit & highest net income. Higher net income may help companies to attract investors and to borrow on favorable terms. ? LIFO: highest COGS, lowest gross profit & lowest net income. Lower income results in lower taxes and higher cash flow. ? Average cost: fall between LIFO and FIFO.
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Advantage of Each Method
Weighted Average First-In, First-Out Last-In, First-Out

Smoothes out price changes

Ending inventory approximates current replacement cost

Better matching of current costs in cost of goods sold with revenues

? Practice: S6-5, 6, p.334.
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Accounting Principles
? ? ? ? Consistency Principle Disclosure Principle Materiality Concept Accounting Conservatism

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Accounting Principles Relating to Inventories
? Consistency principle - use the same accounting methods & procedures from period to period - Inventory methods can be changed, but the change & the effect of the change must be disclosed. ? Disclosure principle - report enough information for outsiders to make knowledgeable decisions - Information should be relevant, reliable & comparable. - Inventory methods must be disclosed.
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Accounting Principles Relating to Inventories
? Materiality concept: a company must adhere to GAAP only for items and transactions that are significant to the business’s financial statements. ? Information is significant or material when its presentation in the financial statements would cause someone to change a decision.

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Accounting Principles Relating to Inventories
? Conservatism: reporting items in the financial statements at amounts that lead to the most cautious immediate results. ? Some guidelines are: - Do not anticipate gains, but provide for all probable losses. - If in doubt, record an asset at the lowest reasonable amount and a liability at the highest possible amount. - When there’s a question, record an expense rather than an asset.
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Other Inventory Issues
? ? ? ? The lower-of-cost-or-market rule Effects of inventory errors Ethical issues Estimating ending inventory

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Lower-of-Cost-or-Market (LCM) Rule
? Example of Accounting Conservatism ? Inventory is reported at whichever is lower – historical cost or market value (current replacement cost) ? Must disclose method of valuation in financial statements
– As parenthetical in statements or – In notes to financial statements

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Lower-of-Cost-or-Market Rule
? If market value is lower than historical cost, write inventory down: DR Cost of Goods Sold XX CR Inventory XX Inventory is written down to market ? →A-13: Amazon.com annual report ? p267: S6-7, 8, p334.

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S6-7
King Burger should make no journal entry to apply the lower-of-cost-or-market rule. The current market value of ending inventory ($450) exceeds cost ($400), so no adjustment is needed. Therefore, report ending inventory as follows: Balance Sheet Current assets: Inventory, at average cost (which is lower than market) $400
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S6-8
Cost of Goods Sold ($400 ? $360) 40 Inventory 40 Balance Sheet Current assets: Inventory, at market (which is lower than average cost) $360
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Inventory Errors
? Ending inventory affect balance of inventory, cost of goods sold, gross profit, & net income in the period that the error occurs (Period 1). ? Inventory errors reverse (or counterbalance) in Period 2 and have the opposite effect on cost of goods sold, gross profit, and net income. ? Exhibit 6-9 (p.327): an example of an inventory error
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Inventory Errors
? If ending inventory is overstated, so is net income and gross profit. Cost of Goods sold is understated. ? If ending inventory is understated, so is net income and gross profit. Cost of Goods sold is overstated. ? In year two, the effects of year one are reversed ? Exhibit 6-10 (p.327): the effects of an error on two periods.

? Practice: S6-9,10, p.335.
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S6-9, 6-10
? S6-9 Cost of goods sold of 2008 would be $28,000 ($27,000 + $1,000). Gross profit of 2008 would be $22,000 ($23,000 ? $1,000). ? S6-10 Cost of goods sold of 2009 would be overstated by $1,000. Gross profit of 2009 would be understated by $1,000.
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Ethical Issues
? How might companies try to mislead readers of financial statements by manipulating inventory? 1. overstate ending inventory 2. report dubious sales

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Estimating Ending Inventory: Gross Profit Method
? Estimate ending inventory by applying the gross profit ratio to net sales ? Useful when inventory has been destroyed, lost, or stolen

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Things to Remember
? Compute Gross Profit:
Sales - Cost of Goods Sold Gross Profit

? Compute Gross Profit Percent:
Gross Profit / Net Sales
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Things to Remember
? Compute Cost of Goods Sold Beginning inventory + Purchases - Purchases returns + Freight-in = Goods available for sale - Ending inventory = Cost of goods sold
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Estimation of COGS
? The cost of goods sold (above) is estimated using the following formula (Exhibit 6-11): Net sales revenue (Sales revenue – returns & allowances – discounts) - Estimated gross profit (Sales revenue x
gross profit rate)

= Estimated cost of goods sold
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Estimation of Ending Inventory
Ending inventory

Beginning inventory + Purchases = Cost of goods available for sale - estimated Cost of goods sold = Ending inventory
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XX XX XX (XX) XX
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Illustration
? Assume that the records for an auto firm show the following: Beginning inventory $150,000 Net purchases 800,000 Net sales 1,000,000 Gross profit rate 40% ? Suppose this inventory was lost in a fire. Estimate the amount of the loss. Use the gross profit method.

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Illustration
Sales - Cost of Goods Sold Gross Profit Sales - Cost of Goods Sold Gross Profit 100% 60% 40% $1,000,000 600,000 ???? 400,000

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Illustration
Beginning inventory $150,000 + Purchases 800,000 Goods available for sale $950,000 ???? 550,000 - Ending inventory Cost of goods sold $400,000 ? Practice: S6-11, 12, p.335.
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S 6-11
Beginning inventory +Purchases =Cost of goods available ?Cost of goods sold =Ending inventory $350,000 1,600,000 1,950,000 (1,750,000) $200,000

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S6-12
Beginning inventory + Purchases = Cost of goods available ? Cost of goods sold $50,000 250,000 300,000

Sales revenue $500,000 Less estimated gross profit(55%) 275,000

Estimated cost of goods sold = Estimated cost of ending inventory
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(225,000) $75,000
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Assignments
1. P6-28A 2. P6-29A 3. P6-30A optional: 1. P6-31A 2. P6-32A 3. P6-33A.
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Learning Objectives(revisited)
1. Compute perpetual inventory amounts under FIFO, LIFO, and average cost 2. Record perpetual inventory transactions 3. Compare the effects of FIFO, LIFO, and average cost 4. Compute periodic inventory amounts under FIFO, LIFO, and average cost 5. Apply the lower-of-cost-or-market rule to inventory 6. Determine the effects of inventory errors 7. Estimate ending inventory by the gross profit method 2013-4-4 chapter6-merchandise inventory49
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